March 30, 2009

During the Republican Presidential primary campaign in 2007 and early 2008, Congressman Ron Paul (R-TX) insisted on talking about such outré topics as the dangers of the Federal Reserve System and fiat money, for which he was widely snickered at. Back then, everybody just knew that the geniuses at the Fed had solved all our fundamental economic problems. Now the only one that remained was (as Barack Obama kept pointing out) how to more equitably divvy up the endless stream of wealth.

Granted, when your kids would ask you why a dollar bill was worth a dollar, you’d start out confidently enough, but soon find yourself waving your hands around and answering their increasingly skeptical questions with "Because Daddy says so!"

Yet, even though you, yourself, might be a little hazy on the details, you could be confident that Alan Greenspan and his protégé Ben Bernanke had this money thing all figured out. So, why listen to Ron Paul talk about something as obviously obsolete as the gold standard?

Early 2008 sure seems like a long time ago now …

Perhaps not surprisingly then, one of the surprise bestsellers of 2009 is Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods Jr., a historian with the Ludwig von Mises Institute. Despite almost no reviews in what Treasury Secretary Tim Geithner might euphemize as the "legacy press"— Woods’s book (with its Foreword by Rep. Paul) has risen as high as #11 on the New York Times bestseller list.

Woods points to six main causes for the current economic travails, which began with the rise in mortgage defaults in 2007 (largely in the four Sand States). His assessment overlaps considerably with the under-reported aspects that I’ve emphasized:

“The Federal Reserve and artificially cheap credit”: Woods sees the low Fed interest rates that bottomed out at 1 percent in 2003-2004 as the worst culprit

The great sportswriter A. J. Liebling boasted: "I can write better than anybody who can write faster, and I can write faster than anybody who can write better," and Woods does a fine job of hitting Liebling’s sweet spot in lucidly presenting an Austrian School of Economics analysis of our current troubles.

The "Austrians" (most of whom are American these days) have been waiting a long time for an opportunity to make their case.

27 comments:

Woods is a smart man but even so he's wrong about the mortgage-interest deduction promoting ownership over renting. In fact, since apartment landlords also deduct mortgage interest, the mortgage interest deduction per-se does NOT promote owning over renting. The deduction has the same effect on monthly payments whether you take it or your landlord takes it (in a competitive rental market-- and nearly all rental markets in the USA are fully competitive).

There actually is a tax policy which promotes owning over renting. That is the exclusion of imputed rental value from income. However, that policy was not created to promote ownership or subsidize minorities. It's simply a reflection of the extreme difficulties of valuing imputed rent and of collecting taxes in cash on purely notional income. (As well as the difficulty of explaining to granny why she should pay taxes on the income she could hypothetically earn if only she relocated to a shopping cart so she could rent out her house.)

I don't know where the idea that mortgage interest deductibility favors ownership came from originally. I think the idea persists now as a kind of folk wisdom, but it's not true. Perhaps people believe that it must be a subsidy just because it's such a big item on the middle- and upper-class tax form. Mortgage interest deductibility is really neutral between owning and renting.

(You might propose eliminating the deduction for homeowners (not landlords) as a rough substitute for taxing imputed rental value. I haven't tried to figure out whether the amounts of money involved are really similar, but I do think the distributional effects of such a policy would be uneven. I suspect in the long run such a change would benefit older and richer folks at the expense of younger and poorer folks. In the short run it would harm current homeowners and mortgage-payers. The former because the value of the M-I deduction is capitalized into housing prices (so those would fall), the latter because their taxes would increase a lot.)

Steve, Why so little attention to our trade deficit with China artificially created by Chinese monetary authorities (they bought US Treasuries in order to keep the value their currency low and the volume of their exports high)and the way this flooded our capital markets with investable funds?

Since real interest rates are set by supply and demand (the Fed can only tweak them) and asset prices are inversely related, the run up in asset prices would seem almost inevitable. Indeed, how could it have been avoided?

Note well that the guy who first worked out the details of the "Austrian Business Cycle Theory" -- Friedrich Hayek -- didn't say that the Fed had to create the systematic distortion in the time structure of the production economy (housing and cars are part of that structure).

Hayek's theory included systematic "delusions" and "over optimism" among lenders and borrowers.

So don't think you've grappled with the implications of the Hayek / Austrians model on the current if you've dismissed the Fed as the cause of this whole thing. You haven't.

While the US mortgage mess may have acted as a gunshot, clearly this was an International financial avalanche. Wreckless activity was happening everywhere. Remember Iceland? Did someone mention China? Bernie Whathisname fits in here somewhere.

We seem to have created an unstable system in which a handful of fools can bring on chaos. I suspect the "computerization" of money is a major factor.

Russia is proposing going to the gold standard. It benefits them, they have lots of gold.

It's probably inevitable as the dollar inflates that many countries that are import-dependent will go to the gold standard.

Because there is no dollar to peg to and keep currencies stable and not basically worthless. Argentina, Chile, Peru, and many of the Eastern European nations outside the EU currency union will have to do that, all are import-dependent and face massive social unrest with constantly rising prices for food and fuel.

Paul was certainly right about that, I certainly was wrong too. He clearly saw the degree to which governments will debase currency by simply printing lots of it. The EU basically told Eastern Europe to get lost for rescue, they have their own problems.

The Gold standard has many problems, but it's really the only alternative to most nations when the dollar goes kaput. Which it certainly will with Obama's spending plans.

Hayek had nothing to do with the origin of business cycle theory. Rather, he attempted to explicate the theory already developed in a series of books by Mises (the first of which appeared in 1912) and with the addition of some ideas of his own which he felt had some influence in the process (psychological in nature). At one time he stated that he only meant to explain Mises' theory, that he accepted Mises' theory as entirely correct, that if, in any respect his statements were at odds with Mises' theory, his own were mistaken, and that his own contributions (the psychological parts) were more or less hypotheses he held and could not be proven in the rigidly logical manner of Austrian economic science.

At this point, I'd explain what we know as "banking" because confusion in the terminology is at the root of misunderstanding of the process.

The word "bank" comes from Italian "banco," (table), referring to the tables on which Italian bankers (actually, "moneylenders," conducted business. Such bankers made loans of their own (to include investors--not "depositors")MONEY. Such loans have no effect on the quantity of money in circulation (and which quantity influences the opinions people express on the market as prices and interest rates). The modern banking business grew from the discovery by English goldsmiths of two things: 1.) that they could earn income by storing peoples' money for them and that the receipts could actually circulate, themselves, just like money; and, 2.) that, since many of those storing money (gold, silver) would consent to its use to make loans (if they didn't, they had to pay for storage rather than getting part of the interest), most of the actual money tended to stay in their keeping, with receipt comprising p[art of normal circulating currency AND, since few wanted their actual money at any one time, the banker could write receipts for more gold than was on deposit and, by making loans for which the borrower received receipts ("notes"), could earn interest on essentially non-existent money. All banks can do this but must be very careful to do so only within limits whhich their own capital might cover and with particular attention to the volume of notes circulating in the areas of other banks, who would return them for redemption as quickly as practical, putting a practical limit on note-circulation. This latter is what "central banking" attempts to offset in order to increase the "extra money" to a degree greater than that merely constituted by the sum of all the individual banks' ability to float their over-issue.

"Austrians" do not espouse their theories (ABCT or any other) because they favor the free market; the case is the exact opposite: they favor the free market because it is the system consistent with sound economic principles and the maximization of human peace, prosperity, production, and happiness. It (the free market) is the single system in which everyone gets exactly what everybody else ("the market") thinks of his contribution and is the only system without built-in perks for political corruption, the confiscation of some for the benefit of others, or the setting aside of protected preserves for the benefit of a favored few.

The free market, even in its much-hampered present state, has provided a most advanced state of material prosperity in the short space of its duration to more people than have even existed in the previos generally impoverished state of the world since the dawn of civilization.

It (the free market) is the single system in which everyone gets exactly what everybody else ("the market") thinks of his contribution and is the only system without built-in perks for political corruption, the confiscation of some for the benefit of others, or the setting aside of protected preserves for the benefit of a favored few.

Which is utopian, as those with wealth will always use it to buy influence and increase their wealth.

I have never seen any evidence that the Austrians, or libertarians in general, have the slightest understanding of how freedom is created and flourishes. Their own prescriptions, notably in the fields of ethics and psychology, have done a great deal of damage to the free market.

Free market capitalism was born with the rise of what were called the "bourgeoisie virtues", and as we are seeing, it will not survive their demise. The Joseph Cassano's of the world signal the end of the old order. Or perhaps the desperate need for a Reformation.

There actually is a tax policy which promotes owning over renting. That is the exclusion of imputed rental value from income.

No, the policy is even-handed there as well. The rental value of an owner's home (house) is excluded, yes, but the rental value of a renter's home (apartment) is likewise excluded. So is the rental value of your car and of the shirt on your back. The value of the things we buy with income does not itself constitute income either under the law or in theory.

I read The Creature From Jekyll Island and in it the author shows how fractional reserve banking began in northern Italy, not England. The bank cited by the author was in existence around the time of the Renaissance, if I remember correctly.

I have never seen any evidence that the Austrians, or libertarians in general, have the slightest understanding of how freedom is created and flourishes. Their own prescriptions, notably in the fields of ethics and psychology, have done a great deal of damage to the free market.

I don't think it's fair to lump the Austrians in with the libertarians.

You want a free market, the Austrians can show you how to run a damn fine one. They're not even reflexively anti-government.

Libertar(d)ians on the other hand, for them bashing government and flaunting social mores is virtually a religious duty.

Mark Seecof:Woods is a smart man but even so he's wrong about the mortgage-interest deduction promoting ownership over renting...

Even if the tax code doesn't discriminate against landlords who rent to tenants [vis-a-vis single-family homeowners], it's still the case that ANY tax deduction will [tend to] alter economic activity away from what the free market would have engaged in otherwise.

Once you declare that a thing [like mortgage interest] is sacrosanct, then the tax code becomes nothing more than a means of subsidizing the thing artificially, and if you subsidize a thing artificially, then you tend to get an oversupply of it.

And our whole problem here is that the gubmint has so badly distorted the pricing mechanism in the real estate market that we still aren't quite sure what any of it is worth [or ought to be worth, in a perfect world].

Beyond that, we've now created a generation or two of co-dependents who, when they decide they want "X", go crying to the government, demanding: "Wah wah wah, gimme a subsidy for 'X'".

And that's not a recipe for a healthy, functional, serious, sober, adult society - it's a prescription for infantilism.

[And we haven't even touched on the underlying problem of equality before the law - the ideal which holds (among other things) that the legal code musn't be involved in discriminating either for or against any particular form of enterprise.]

You're not an economic idiot; you're an economic ignoramus (there's a difference.

But I'm only teasing and i have a suggestion, which, if you follow, I'm sure you'll find very worthwhile.

Somehow, get hold of the book by Henry Hazlitt, "ECONOMICS IN ONE LESSON." Once you've read that you'll know more than most people who talk (and comment on blogs) about economic matters. What's almost as important, you'll know that what you know is sound.

You might even decide you like knowin' about that stuff and decide to go for more.

Steve,Your experience of 1983 might be explained by the late Jude Wanniski, a Supply Sider influenced by the Austrians. He wrote (http://www.polyconomics.com/memos/mm-040618.htm):

"The plunge that preceded the Reagan expansion is the reason Reagan defeated Carter. The Keynesians who advised the Carter administration counseled an ever-weakening dollar to make exports cheaper. When Paul Volcker, a conservative Keynesian and a Democrat was named to head the Fed in the late spring of 1979, the Democratic monetarists who controlled the staffs of the House & Senate Banking Committees urged a Fed switch in its operating mechanism, targeting the monetary aggregates instead of interest rates. The plan was to push the economy into expansion with aggressive monetary policy and Volcker complied by stating in October 1979 that because the economy would grow faster in the year ahead, more liquidity would be needed to accommodate the expansion. At the same time a system of capital controls was instituted, which reduced the demand for liquidity. The net effect was a flooding of the banking system with liquidity that it did not need or want. The price of gold soared from $240 when Volcker took office to $850 per ounce on Feb.1, 1980. It tailed off a bit when the Fed adjusted the flow, but was still about $650 oz when Reagan was elected in November 1980.

"The “plunge” to which Krugman refers was the result of the monetary deflation that brought the gold price down to $300 by March 1982. This was not Volcker’s doing, but the side-effects of the Reagan tax cuts of 1981, which were properly aimed at expanding the sluggish economy. This kind of expansion really did lead to an increase in demand for liquidity. When the Fed clung to its monetarist targets instead of supplying that liquidity, dollars became scarce relative to gold and the gold price rapidly ran down to $300. Throughout 1981 I warned my clients and in the public prints this was the problem. In November 1981 Robert Mundell warned that the Reagan administration should intervene and stabilize the gold price between $400 and $425 to prevent the deflation he could see coming.

"These papers are all on the record, including a letter I got from President Reagan in October 1981 in response to a note I sent him warning of consequences of deflation. He answered simply that he was getting “divided counsel” and that “Milton F” was assured him that by holding to his course, there would soon be a sharp decline in interest rates. Keynesians actually also warned that monetary policy was offsetting the fiscal effects of the tax cuts, but it was not until Mexico could not pay interest on its massive debts to American banks in August 1982 that the “plunge”turned into “expansion.” That is because Volcker had to monetize $3 billion in Mexican peso bonds so Mexico could pay the U.S. banks. To do this, he had to tell the Reagan Treasury department that he had to set aside the monetarist money targets. That was effectively the end of monetarism."

Wanniski also had a different explanation about the dot-com bust than did most of the Austrians, including Woods.

Wanniski based his analysis on a theory of the most famous Austrian, Mises himself, in pointing to the DEflation of the late 1990s to 2001. W. noted the decline in the price of gold (from about $350 an ounce to $255 at the lowest). He said the later Austrians, led by Rothbard's disciples, instead of looking at the price of gold, looked at the increase in the money supply of the 1990s, which Wanniski saw as just meeting the demand for money in an expanding economy and therefore not detrimental. (Wanniski and the Austrian folk would be on the same page for the current inflation, with both its tripling of the price of gold and surge in the money supply.)

A discussion of this from 2002 between Wanniski and Gary North is here:http://www.polyconomics.com/ssu/ssu-020104.htm

This is relevant because, for Wanniski, the DEflation was bad, but justified the low interest rates for that short period -- until Greenspan reversed course after 9/11 and began the current INflation. At that point -- roughly sometime in 2002 -- interest rates should have been increased, but were NOT increased, causing the typical Austrian boom/bust cycle in housing, etc., from which we now suffer.

""The Community Reinvestment Act and affirmative action in lending": the government acted as if the big danger was too little lending to politically favored groups instead of too much"

No no no NOOOOOO.

I make a point on my crappy lil blog about this. The point is, that America is 70% (or more, in reality) service economy.

Service economy is banking, finance and insurance (and then little crap like the small business folks, barbers, restaurants and the like).

So, the American government, BOTH republicans and republicans, with B. Clinton alongside the suddenly communist GWbush, all pushed for loans to be given to ever more dubious recipients.

The whole point of the housing bubble is that it supported the (biggest, the real) part of the American economy - the service part.

Banking, finance and insurance all benefited tremendously from the housing bubble.

And both parties, and all politicians, were rah-rah for this bubble.

More loans - give people loans backed up by loans on their unpaid hosue! Buy more stuff, market goes up and up, finance gets to play with people's 401K's and investments, insurance insures crappy loans and suddenly (presto! magic!) those bad loans insured become CREDIT, a gain, revenue on the ledgers as opposed to a write off...

Actually, wrong tack - be simplistic, it is really very simple.

The trick is to realize that BOTH parties were all for it, from the top down, for years.

Anyways - Obama trying to reform the healthcare insurance is the elite trying to salvage (half assed) what's remaining of the real American economy (not paper shuffling and financial "magic") but it is already too late.

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